FICC Research

Interest Rates
18 October 2023

US Rates Research

Moving the anchor

FOCUS
Bond markets remain volatile, with 10y yields making new
highs. We have argued over the past several months that
despite the end of the hiking cycle in sight, it is not the time to Anshul Pradhan
+1 212 412 3681
go long duration. Given the recent move higher in yields, we anshul.pradhan@barclays.com
BCI, US
revisit our analysis. While some things have changed, our
Samuel Earl
conclusion has not. + 1 212 526 5426
samuel.earl@barclays.com
• We do not think yield levels are stretched. Despite the sharp selloff, 10y yields are still below BCI, US

the expected terminal rate in this hiking cycle, which is at odds with how hiking cycles have Demi Hu
typically ended. In other words, the term premium embedded in long-term yields has risen, +1 212 526 7398
but from low levels; it is not out of line with its fundamental drivers, such as rate volatility. demi.hu@barclays.com
BCI, US
• The hurdle for a rally is still high. Despite data continuing to show a resilient economy,
the consensus still expects it to slow very sharply over the coming quarters. Repeated misses
beg the question whether the consensus has been overly confident about monetary policy
being too tight. We argue that policy is barely tight and risks are skewed towards continued
upside surprises.

• We have also cautioned that bond markets were not paying enough attention to the
potential for persistently wide budget deficits. We remain of the view that the fiscal picture
looks daunting and absent fiscal consolidation, deficits are likely to be worse than projected
because of the higher cost of servicing debt. Tactically, however, there is scope for duration
supply relief at the upcoming refunding meeting (see Tempering the issuance tsunami).

• We have, moreover, argued against extrapolating from past hiking cycles and expecting a
bond market rally following the last hike, as initial conditions prevailing today are quite
different (see In the endgame: Will history repeat?). With rising yields and falling inflation,
conditions have become more conducive for a rally over the medium term, but still a fairly
modest one. Downbeat expectations about the economy for the near term suggest this rally is
likely to be delayed.

• Further, market dynamics still entail negatively convex flows, which could exacerbate a sell-
off. Asset managers are significantly long the bond futures contract and would face extension
risk in a back end-led selloff. In a similar vein, recently issued negatively convex mortgages
are likely to be held by active hedgers, who also have to contend with duration extension in a
selloff.

This document is intended for institutional investors and is not subject to all of the
independence and disclosure standards applicable to debt research reports prepared for retail
investors under U.S. FINRA Rule 2242. Barclays trades the securities covered in this report for its
own account and on a discretionary basis on behalf of certain clients. Such trading interests
may be contrary to the recommendations offered in this report.
Please see analyst certifications and important disclosures beginning on page 10.
Completed: 18-Oct-23, 15:05 GMT Released: 18-Oct-23, 15:10 GMT Restricted - External
Barclays | US Rates Research

Overall, in light of the continued strength of the economy, despite an elevated policy rate,
the anchor for yields is shifting to the overnight policy rate as investors question their
assumption of a low long-term neutral rate (see Return to normal). We therefore view an
abrupt slowdown in the economy or a financial market shock, either of which would suggest
yields have gone too far, as prerequisites for a sustained rally. We discuss valuations, key drivers
and market dynamics below.

FIGURE 1. Bond market realized volatility has risen sharply

450
10y day realized vol of 30y yields, annualized, bpv
400

350

300

250

200

150

100

50

0
Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15 Jan-20

Source: Bloomberg, Barclays Research

From riches to rags? Not yet

While bonds have been extremely volatile of late (Figure 1), we do not think yield levels are
stretched yet, for a couple of reasons:

First, a simple comparison of 10y yields to the policy rate at the end of the hiking cycle suggests
they are not high (Figure 2). They are still 60bp below the expected terminal rate (4.85% vs.
5.45%), which would still put them at odds with how historical hiking cycles have ended. At the
time of the last hike, 10y yields were above the fed funds rate by 0.3pp, on average (from 1984 to
now), though with significant variation (-0.7pp to +1.5pp). While the inversion had dissipated to
an extent, it is still at the lower end of the range.

Further, the market is still pricing in the Fed to cut 75bp, to a 4.75% fed funds rate, by the end of
next year. Should that get priced out, 10y yields could rise another 50bp, in our view. There is
only so long that one can hold a negative carry position when the price return is not in sight.

FIGURE 2. Hiking cycles have typically ended with the 10y yields at or above the policy rate

14
10y Treasury yield, % FF rate, %
12

10

0
Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15 Jan-20

Source: Haver Analytics, Barclays Research

18 October 2023 2
Barclays | US Rates Research

Second, from a first principles perspective, one can decompose long-term yields into the
expected path of the policy rate over the horizon of the bond and the term premium. A high
term premium would make bonds attractive over a medium-term horizon, as holding them
relative to rolling over T-bills would result in a healthy excess return. In the near term, however,
the term premium itself can move higher to account for current conditions.

To estimate the term premium, Figure 3 shows our expectation of the path of policy rate (using
a small-scale model of the economy and r-star path from the NY Fed DSGE model) and Figure
4 shows what that means for the expected average policy rate over different tenors (forward to
year-end).

At the 10y tenor, the average expected policy rate is about 3.95% at year-end, which, with 10y
yields trading at 4.8% forward to year-end, implies a term premium of 85bp. After accounting for
the 30bp of 10y swap spread, which can be attributed to Treasury supply concerns, the rate
term premium is 55bp.

Is that high? We do not think so. Figure 5 shows that our fair value estimate of the term
premium (accounting for the level of rate volatility and far-forward inflation swaps) is 60bp, with
a one standard deviation band of 35-85bp. The primary reason why this is higher than the pre-
COVID level is that interest rate volatility has risen sharply, which reflects heightened
uncertainty about the macro outlook (Figure 6). Inflation swaps are also higher than pre-COVID
levels (Figure 7). Hence, we do not view the term premium embedded in long-term rates as
excessive. Further, the stronger-than-expected economy in H2 23 points to an even higher
trajectory of r-star than assumed and suggests upside risks to the expectations component.

In all, from a level perspective, we believe yields have not reached a level where one can
argue that they have peaked.

FIGURE 3. Path of short rates from a small-scale model... FIGURE 4. ...and the resulting expectations and term premia curve
Fed
Fwd to Q423, Term Rate Term
Tsy yields Expectation ASW
% Premium Premium
s
2s 5.05 5.32 -0.27 0.13 -0.39
5s 4.80 4.46 0.34 0.25 0.09
10s 4.80 3.93 0.87 0.32 0.55

Source: New York Fed, Barclays Research Source: Barclays Research

18 October 2023 3
Barclays | US Rates Research

FIGURE 5. Fair value of the rate term premium is significantly positive, given higher volatility

2.0 Fair value of TP, %

+1sd
1.5 -1sd
1.0

0.5

0.0

-0.5

-1.0

-1.5
Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 Dec-18 Dec-20 Dec-22

Source: Barclays Research

FIGURE 6. Interest rate volatility is quite high in a historical context FIGURE 7. Inflation swaps have also risen from pre-COVID levels

190 4.0
1y10y interest rate vol, bpv
5y5y CPI swaps, %, lhs
170
3.5
150

130 3.0

110 2.5
90
2.0
70

50 1.5
Jan-05 Jan-08 Jan-11 Jan-14 Jan-17 Jan-20 Jan-23 Jan-05 Jan-08 Jan-11 Jan-14 Jan-17 Jan-20 Jan-23

Source: Bloomberg, Barclays Research Source: Bloomberg, Barclays Research

Consensus is still pessimistic: Is policy even tight?

Given the wide range around any estimate of fair value, it is useful to think about catalysts for a
move. One is that despite data continuing to show a resilient economy, the consensus still
expects the economy to slow very sharply. This not only keeps the bar high for downside
surprises and bonds to rally, but more importantly begs the question whether the consensus is
overly confident about monetary policy being too tight.

Figure 8 shows how real GDP growth forecasts have evolved. Late last year, the consensus was
that the US economy would be in a recession in H1 23; with the passage of time, that the
magnitude of the slowdown has been pared back, but it is still expected. The consensus expects
growth to slow into early next year, but the arguments for such a scenario are fading, in our
view. Labor income is growing at a solid pace in real terms, and the household saving rate
remains low, reflecting the boost to net worth and stock of excess savings, suggesting
consumption growth should remain strong.

Similarly, markets remain priced for inflation to fall sharply, with y/y CPI priced to decline to
2.5% by the end of next year, though the underlying data have worsened. Figure 9 shows that
the recent disinflation was in pandemic-sensitive categories and is beginning to decline. Should

18 October 2023 4
Barclays | US Rates Research

it completely fade, core CPI should print 0.4% in the next few months, which would still be an
upside surprise.

The above begs the question: is policy even tight, despite what the Fed claims? Figure
10 shows the nominal policy rate, underlying inflation (using 6m Dallas trimmed inflation) and
the resulting real policy rate. Figure 11 shows the current estimate of the neutral rate (using the
New York Fed DSGE model1 ). While the real policy rate has risen significantly, it has done
so from very negative levels, to about 2.0%. That is actually somewhat short of the 2.5% short-
term neutral rate that is estimated currently. One could say forward-looking measures are
tighter; true, but barely. The 5y real rate is 2.2% (using SOFR and CPI swaps, adjusted for the
CPI-PCE basis) and the 5y average neutral rate is estimated to be 1.9% (Figure 11). A 0.3pp tight
policy is unlikely to slow the economy as sharply as expected.

Eventually, if history is any guide, the recession, when it happens, is likely to be deeper than
the consensus expects, but is also likely to be a surprise. With the consensus still a 55%
probability of a recession, even if a mild one, this suggests that the time to go long
duration has not arrived yet.

FIGURE 8. The consensus has been too quick to fade the strength FIGURE 9. Core inflation should be sticky over the coming months

3.5 Median real GDP forecast, QoQ % SAAR 1.0 Contribution of pandemic sensitive sectors to m/m core CPI
3.0
0.8 Contribution of other core sectors, %
2.5
2.0
0.6
1.5
1.0 0.4
0.5
0.2
0.0
-0.5 0.0
Feb-23 Mar-23 Apr-23
-1.0 May-23 Jun-23 Jul-23 -0.2
-1.5 Aug-23 Sep-23 Oct-23 Dec-20 Jun-21 Dec-21 Jun-22 Dec-22 Jun-23
Dec-22 Jun-23 Dec-23 Jun-24 Dec-24

Source: Bloomberg, Barclays Research Source: Haver Analytics, Barclays Research

FIGURE 10. The real policy rate is positive... FIGURE 11. ...but not as much as the estimate of the overnight real
policy rate

10 Nominal Funds Rate, % 3.0

R-star, NY Fed DSGE model
2.6
8 Dallas 6m trimmed mean PCE inflation, % 2.5
Real Policy Rate, % 2.5
2.2
6
1.9
2.0
4
1.6
2 1.5
1.1
0
1.0
-2
0.5
-4

-6 0.0
Dec-90 Dec-95 Dec-00 Dec-05 Dec-10 Dec-15 Dec-20 2022 2023E 2024E 2025E 2026E Fed's LW

Source: Haver Analytics, Barclays Research Source: New York Fed, Barclays Research

1
https://www.newyorkfed.org/research/policy/dsge#/interactive

18 October 2023 5
Barclays | US Rates Research

Budget deficits are here to stay, with tactical duration

supply relief
Another reason we have cautioned against expecting a bond market rally is the return of
persistently wide budget deficits (see Deficits are back with a bang, Treasury Supply: Up, up and
away and Treasury tsunami). With the Treasury forecasting a $2trn financing need for FY23,
investors finally took notice, wondering who will buy all of this supply. We maintain our view
that the fiscal picture looks daunting and absent meaningful fiscal consolidation, the medium-
to long-term picture is likely to be worse than expected. Tactically however, there is scope for
duration supply relief.

Given the sharp rise in the term premium and strong demand for T-bills, the Treasury is likely to
signal at the upcoming refunding meeting more willingness to rely on T-bills (see Tempering the
issuance tsunami). This should lead to less duration supply than feared and would be welcomed
by the market. Whether that will be sustained is a different matter. The likely scenario is that
investors repeatedly revise their budget deficit forecast higher.

The consensus expects the budget deficit to be 6% of GDP in 2024 and 2025. To put that in
perspective, in 2023 it is estimated to be 7.5% GDP (or about $2trn after adjusting for student
loan accounting, Figure 12). While there is likely to be some improvement, a
1.5pp decline seems excessive. We believe a deficit of 6.5-7% is more likely. Beyond the next
couple of years, interest costs will start to account for a large share of it, particularly as debt
levels rise beyond 100% of GDP (Figure 13). Even if the primary deficit is 3-3.5% of GDP, the total
deficit would rise to 8% GDP. In USD terms, it is likely to be back at $2trn in a couple of years and
on course to $3trn by the end of the decade. Even as QT ends, the Treasury's financing needs
will worsen over time.

Ultimately, the amount of debt will weigh on Treasuries, which have cheapened relative to
SOFR, with 10y and 30y swap spreads tightening to -30bp and -70bp. Our models suggest that
given the deficit outlook, they should be tighter still.

Hence, while tactically there is likely to be duration supply relief as the Treasury relies
more heavily on T-bills than the market expects, medium- to long-term concerns would
remain.

FIGURE 12. The budget deficit has widened significantly FIGURE 13. Interest costs are likely to rise sharply as a share of GDP

5.0
fiscal year to date budget deficits, $bn Int cost, % GDP
4.5
0
Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep 4.0

-500 3.5
3.0
-1,000 2.5
2.0
-1,500
1.5
1.0
-2,000
0.5
-2,500 0.0
2022 2023 2022-Adj 2023-Adj 1965 1975 1985 1995 2005 2015 2025

Adjusted shows deficit without student loan cancellation. We assumes yields fall over time, with bill yields approaching the long-term neutral
level and intermediate yields retaining a term premium.
Source: CBO, Barclays Research Source: CBO, Barclays Research

18 October 2023 6
Barclays | US Rates Research

End-of-cycle bond market rally? Starting conditions

still not conducive
We have also argued that investors should not extrapolate from past experience of end of hiking
cycles and expect a bond market rally, as initial conditions were quite different. With the move
since summer, they point to the potential for a rally over a 12-month horizon but still a modest
one. We discuss them briefly here (for details, see In the endgame: Will history repeat?).

• The extent of policy easing expected at the end of past hiking cycles, proxied by the
slope between the 10y rate and the fed funds (FF) rate (Figure 14).

• The distance from the dual mandate, proxied by the difference between the unemployment
rate and core inflation (Figure 15).

• Tightness of policy at the last hike, proxied by the real policy rate (fed funds rate minus y/y
core inflation rate) versus the r-star estimate. We use long-term r-star for this exercise, as that
is available over time (Figure 16).

• The measure of the term premium embedded in 10y yields, proxied by 10y yields minus
the estimate of long-term inflation and long-term r-star expectations (Figure 17).

As can be seen, 10y yields are below the policy rate, the Fed is still constrained by high
inflation amid a low unemployment rate, and monetary policy is barely tight. Given the
move over the last three months, the term premium has indeed risen, which makes a case for
lower yields. However, when the above are accounted for in a historical analysis, the scope for a
rally still seems limited. Figure 18 shows the average expected rally is 30-35bp. To put this in
context, Figure 19 shows that the variation across cycles is significantly larger.

Needless to say, if the economy weakens more than the consensus expects, the rally
would likely be larger, but that argument cuts both ways. If the economy is stronger, 10y yields
may sell off further. With downbeat expectations of growth over the coming quarters, the latter
is a bigger risk.

FIGURE 14. Historically, the larger the inversion, the smaller the rally FIGURE 15. Higher inflation at the last hike has resulted in a
following the last hike subsequent selloff

Change in 10y yields over 12m after last hike, pp

Change in 10y yields over 12m after last hike, pp
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
-0.5 -0.5
-1.0 -1.0
-1.5 -1.5
-2.0 -2.0
-2.5 -2.5
-3.0 -3.0
-6 -4 -2 0 2 -4 -2 0 2 4
10y rate vs the FF rates, pp UR minus core PCE inflation, pp

Source: Haver Analytics, Barclays Research Source: Haver Analytics, Barclays Research

18 October 2023 7
Barclays | US Rates Research

FIGURE 16. High real rates have led to a larger rally FIGURE 17. The term premium is positive, which points to a rally

Change in 10y yields over 12m after last hike, pp Change in 10y yields over 12m after last hike, pp
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
-0.5 -0.5
-1.0
-1.0
-1.5
-1.5
-2.0
-2.0 -2.5
-2.5 -3.0
-3.0 -2 -1 0 1 2 3 4
-4 -2 0 2 4 6 8 Term Premium (10y minus infl and rstar exp), %
Real FF rates vs R-star, pp

Source: Haver Analytics, Barclays Research Source: Haver Analytics, Barclays Research

FIGURE 18. Initial conditions point to scope for a modest rally over the FIGURE 19. However, that looks small compared with typical
medium term variations after the last hike
Implied 12m
Current 400 Change in 10y yields around the last hike, bp
Variables to proxy initial conditions change in
Value (%)
10s (bp) 300
10y yields minus FF -0.6 -54
200
UR minus y/y core PCE inflation 0.1 -16
100
Real policy rate minus rstar 0.3 -26
10y Tsy minus inflation and r-star expectations, 0
0.9 -34
%
-100

-200
Average -32
-300 Nov-66 Jun-69 Jul-74 Mar-80
Jun-81 Aug-84 Feb-89 Feb-95
-400 May-00 Jun-06 Dec-18
T-6m T-3m T+0m T+3m T+6m T+9m T+12m

Source: Haver Analytics, Barclays Research Source: Bloomberg, Barclays Research

Negatively convex flows could exacerbate the sell-off

Finally, market dynamics still entail negatively convex flows which could exacerbate the
sell-off. Asset managers are significantly long the bond futures contract and would face
extension risk in a back-end-led sell-off. Further, recently issued more negatively convex
mortgages are likely to be held by active hedgers, who would also have to contend with
duration extension in a sell-off.

Bond contract CTD extension: Not out of the woods

The US classic bond futures contract continues to be a source of uncertainty for long-duration
hedgers, given the potential implications of a CTD switch to a longer-duration security. Over the
past few weeks, the CTD has switched from Aug39s to Feb40s to Feb41s currently (all original
30y issues). While the duration effect of these switches has been small, the risk of a switch to a
longer-maturity issue remains if the sell-off continues.

Per CFTC data, asset managers' net long positions declined c.60k contracts (through the week
ending October 10). However, they remain elevated (Figure 20). In a bear-steepening scenario,

18 October 2023 8
Barclays | US Rates Research

where the 15-20y sector steepens +5bp and the bonds in the sector cheapen proportionally, the
switch occurs for modest rate sell-offs to longer-maturity 2042-43 issues. (see here for details).

Mortgage convexity: Hedgers likely own negatively convex securities

While the aggregate negative convexity of the MBS universe is low, there is likely a distributional
skew in holdings, where more recently issued higher-coupon mortgages, which tend to be
negatively convex, are held by investors who are more likely to hedge.

With the passage of time, there has been a reconfiguration of the mortgage universe. The Fed
has not been a buyer of MBS for the past year and banks have not been buying, making money
managers the likely marginal buyers of this new issuance. SIFMA data show that monthly
agency MBS gross issuance has been about $100bn per month over the past few months. This is
mostly in coupons higher than 5%. Figure 21 shows that the amount outstanding in fixed-rate
MBS indices in coupons greater than or equal to 5% over the past year has increased about
$650bn, while that in lower coupons has fallen about $400bn. If half the issuance in these MBS
was bought by duration hedgers, that would amount to $300-350bn of securities.

The negative option-adjusted convexity of coupons higher than 5% tends to be 1-1.5 years for
every 1% change in rates. Hence, over the past month's 50bp sell-off, their duration has
extended nearly 0.75y, on average. This implies that duration-shedding needs are
conservatively likely to have been over $25mn in DV01 in the belly and longer tenors just over
the past month (see here for details).

FIGURE 20. Asset manager net long positions in US declined over the FIGURE 21. The higher-coupon MBS universe has grown, while lower
past week... coupons have fallen

Latest data as of week ending 10/10

Source: CFTC, Barclays Research Source: Barclays Research

18 October 2023 9
Barclays | US Rates Research

Analyst(s) Certification(s):
We, Anshul Pradhan, Samuel Earl and Demi Hu, hereby certify (1) that the views expressed in this research report accurately reflect our personal views
about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or
indirectly related to the specific recommendations or views expressed in this research report.
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discretionary basis on behalf of certain clients. Such trading interests may be contrary to the recommendations offered in this report.
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